Bad economic news from Europe

I have been examining and re-examining the situation, trying to find the potential happy ending. It isn’t there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world’s eighth largest economy and third largest bond market. This is triggering margin calls and leading banks to pull credit from the European market. This, in turn, is damaging the European economy, which is already being squeezed by the austerity programmes adopted in every large euro-zone economy. A weakening economy will damage revenues, undermining efforts at fiscal consolidation, further driving away investors and potentially triggering more austerity. The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn’t clear, but it’s unlikely to be pretty.

It is depressing that politicians around the world have put so much effort (and money) into trying to stabilize the global economy all through the complex aftermath of the subprime crisis, and that they have not managed to do so yet. Certainly, Europe’s problems have additional causes, over and above those linked to the previous credit crunch. These include the domestic politics of countries like Greece, as well as the political and monetary design of the European Union and the Euro.

It’s impossible to predict exactly what will happen, but I very much hope the European Union is able to keep together. While there are many practical challenges associated with the project of European integration, it seems like a very positive undertaking from a human perspective. The European Union embodies the recognition that nation-states are too small to deal with the world’s problems and they need to find ambitious and effective ways of working together. That is especially true now, when economic factors threaten to undermine the whole enterprise.

Change in the international system comes in large and small doses, but fundamental patterns generally stay consistent. From 1500 to 1991, for example, European global hegemony constituted the world’s operating principle. Within this overarching framework, however, the international system regularly reshuffles the deck in demoting and promoting powers, fragmenting some and empowering others, and so on. Sometimes this happens because of war, and sometimes because of economic and political forces. While the basic structure of the world stays intact, the precise way it works changes.

The fundamental patterns of European domination held for 500 years. That epoch of history ended in 1991, when the Soviet Union — the last of the great European empires — collapsed with global consequences. In China, Tiananmen Square defined China for a generation. China would continue its process of economic development, but the Chinese Communist Party would remain the dominant force. Japan experienced an economic crisis that ended its period of rapid growth and made the world’s second-largest economy far less dynamic than before. And in 1993, the Maastricht Treaty came into force, creating the contemporary European Union and holding open the possibility of a so-called United States of Europe that could counterbalance the United States of America.

European markets recovered some lost ground Thursday as Italy’s borrowing rates eased somewhat on speculation that a technocratic government led by economist Mario Monti will replace Premier Silvio Berlusconi.

Fears that Italy, the third-largest economy in Europe, could default on its $2.6-trillion (U.S.) debt had sent stock markets plunging Wednesday as Italy’s key borrowing rate spiked way above the 7-per-cent threshold. Greece, Ireland and Portugal had to eventually seek outside financial help when their borrowing rates rose above that level.

Everyone is wondering about the next disaster to befall Europe. Italy is one focus; Spain is also a possibility. But these crises are already under way. Instead, the next crisis will be political, not in the sense of what conventional politician is going to become prime minister, but in the deeper sense of whether Europe’s political elite can retain power, or whether new political forces are going to emerge that will completely reshape the European political landscape. If this happens, it will be by far the most important consequence of the European financial crisis.

Thus far we have seen some changes in personalities in the countries at the center of the crisis. In Greece, Prime Minister George Papandreou stepped aside, while in Italy Prime Minister Silvio Berlusconi now has resigned. Though these resignations have represented a formal change of government, they have not represented a formal policy change. In fact, Papandreou and Berlusconi both stepped down on the condition that their respective governments adopt the austerity policies proposed during their respective tenures.

Countries cannot quit the euro without extreme economic pain, but nor is it easy to fix. Vetoes may be needed to maintain democratic consent, even if they make for poor crisis management. A blockage in one country endangers all. The markets are testing the ambiguities to destruction. Vague promises to “do whatever it takes” to save the euro are not enough. Will the ECB deploy its full resources to stop the crisis? How much intrusion into national policies are Greece and Italy ready to accept? How far is Germany willing to extend its credit? Will the euro zone’s states hang together or hang separately?

These are big questions, affecting the nature of the state, sovereignty and democracy. Mr Papandreou may have messed up his tactics, but he was right on one point. The changes needed to save the euro are so profound in nature that, sooner or later, they must have the explicit consent of the people—or they will fail.

EVEN as the euro zone hurtles towards a crash, most people are assuming that, in the end, European leaders will do whatever it takes to save the single currency. That is because the consequences of the euro’s destruction are so catastrophic that no sensible policymaker could stand by and let it happen.

A euro break-up would cause a global bust worse even than the one in 2008-09. The world’s most financially integrated region would be ripped apart by defaults, bank failures and the imposition of capital controls (see article). The euro zone could shatter into different pieces, or a large block in the north and a fragmented south. Amid the recriminations and broken treaties after the failure of the European Union’s biggest economic project, wild currency swings between those in the core and those in the periphery would almost certainly bring the single market to a shuddering halt. The survival of the EU itself would be in doubt.

Now another run—more hidden, but potentially more dangerous—is taking place: on the continents’ banks. People are not yet queuing up in front of bank branches (except in Latvia’s capital Riga where savers today were trying to withdraw money from Krajbanka, a mid-sized bank, pictured). But billions of euros are flooding out of Europe’s banking system through bond and money markets.

At best, the result may be a credit crunch that leaves businesses unable to get loans and invest. At worst, some banks may fail—and trigger real bank runs in countries whose shaky public finances have left them ill equipped to prop up their financial institutions.

The euro zone still has the capacity to stop this run on its banks and governments. As a block, it is less indebted than America and its public-sector deficit is lower. It has the money to fortify its banks against the default of Greece—and Portugal and Ireland, if need be. And it is minded by the European Central Bank (ECB), which can in principle stand behind those vulnerable governments by buying their debt in unlimited quantities on the secondary market. But the EU has repeatedly failed to put forward a convincing euro rescue. Its latest and bravest attempt, at the end of last month, fell short of the mark—just like all the others. That is because the Europeans are deeply at odds over what the crisis is really about, and riven by disagreement over what each country must contribute towards solving it (see article). So long as the euro zone’s members cannot settle these arguments, or at least agree that their differences matter less than finding a solution, the collective action needed to defend the euro will remain impossible.

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Greece is more likely to buckle under austerity and quit after a succession of governments like the new one. But it would be a desperate act. Banks would collapse and capital flee, and many of Greece’s companies, unable to pay their euro-denominated bills, would go bankrupt. Already shut out of debt markets, Greece would probably lose all financial aid from the EU.

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“The 2008 crisis shows that the dominant economies were not as dominant as they thought,” says Dominique Strauss-Kahn, the French former head of the IMF. “If Europe fails, it will suffer from low growth, economic domination and cultural domination.” Can Europe turn back from the abyss? Only if the core countries will support the rest as they submit themselves to radical political, social and economic reform. Nobody should be under any illusions about how difficult that will be.

Mark Carney, the Governor of the Bank of Canada, idenitifies that the European soverign debt crisis ( and Canadians level of household debt) are the two biggest problems Canadians face. In this interconnected world, I as a Canadian should not feel smug that perhaps we are not facing the sme level of challenges as the European Union. We operaate in an integrated global economy and what occurs in Europe will effect us.

The euroTempted, Angela?
A controlled break-up of the euro would be hugely risky and expensive. So is waiting for a solution to turn up

FOR all you know, Angela Merkel is even now contemplating how to break up the euro. Surely Germany’s long-suffering chancellor must be tempted, given the endless euro-bickering over rescues that later turn out to be inadequate. How she must tire of fighting her country’s corner, only to be branded weak by critics at home. How she must resent sacrificing German wealth, only to be portrayed as a Nazi in some of the very countries she is trying to rescue.

But for this very practical woman there is also a practical reason to start contingency planning for a break-up: it is looking ever more likely. Greece is buckling (see article). Much of southern Europe is also in pain, while the northern creditor countries are becoming ever less forgiving: in a recent poll a narrow majority of Germans favoured bringing back the Deutschmark. A chaotic disintegration would be a calamity. Even as Mrs Merkel struggles to find a solution, her aides are surely also sensibly drawing up a plan to prepare for the worst.